Financial markets

Investing

Paying the premium

Feb 6th 2013, 11:33by Buttonwood

THE idea that equities should produce a higher return than bonds is a well-established concept in finance even though it is far from automatically true; as the London Business School professors report in the new study (referred to in yesterday's post) global bonds have beaten global equities over the last 33 years, a long term by any measure.

Finance academics like to refer to this concept as the equity risk premium (for a longer discussion, see here) and you can break this down into two measures; what investors expected to earn (the ex ante premium) and what they actually get (the ex post premium). The LBS team spends much time discussing what the ex post return has been and what the ex ante return should now be, coming up with a lowish measure of 3-3.5%.

But is the premium a useful idea? Not according to Andrew Smithers, the consultant, who has just produced a (privately-circulated) report called "The Equity Risk Premium: Useless in Practice and a Source of Confusion and Error." He argues that the pricing and returns from equities and bonds are independently determined and thus unrelated. If you look back over 200 years, the long-term returns from equities and bonds were positively correlated in the first half of the period (between 1801 and 1906) and negatively correlated in the second half (between 1907 and 2011).

Smithers' case is also tied up with his long-term view that the real return on equities reverts to the mean, which in the US has been 6% real. Whether the future return will be above or below this mean depends on whether it starts from an over- or under-valued position. He uses two measures of value - the cyclically-adjusted price-earnings ratio or CAPE (familiar to readers of this blog and to devotees of Robert Shiller) and the Q ratio, which compares the share price to the replacement cost of net assets. Both currently show the US market looking substantially overvalued.

He uses this approach to calculate expected real returns from equities and relates it to the expected real returns from US inflation-linked bonds (which is simply the real yield). He finds the resulting ex ante equity risk premium has been remarkably unstable, varying from minus 5% in the late 1990s to almost plus 4% today. If the ex ante ERP is so unstable, it provides no useful information for asset allocators, in his view.

Funnily enough, however, although he uses a different approach to the LBS profs, Smithers comes up with almost exactly the same expected real return from US equities - 3%. And that of course, as recent posts have suggested, is well below the historic average and well below what pension funds are relying on.